Sunday, 21 June 2015

Intrinsic Value - Discounted Cash Flow Model

This is the next part of calculating intrinsic value, where another way to value a share, the Discounted Cash Flow Model (DCF Model) will be introduced. This model is very similar to the Dividend Discount Model (linked to the post) and I would advise that you read the section on it before coming here to get a better understanding of some of the key terms as well as methods to calculate.

Discounted Cash Flow Model 

And we're back to cash
(Image source:

The DCF Model relies on using the company's Free Cash Flow or as some would like to call, owner's earnings, as this is the amount of money that can be taken out of the company without affecting the overall health and stability of the business each reporting period. To understand how to read the Cash Flow Statement of a Financial Statement, please refer to my previous post on it here: Understanding Financial Statements (Part 3) - The Cash Flow Statement. To calculate Free Cash Flow, take the cash used in operating activities minus capital expenditure (money used to purchase and maintain PP&E in a company).

This model is very similar in terms of calculation as the dividend discount model and hence would encourage you to refer to it. In this part, I would be covering on their different uses instead of their calculation.

The DCF Model can be used on most companies except loss-making enterprises, while the DDM can only be used on companies that pay out dividends. Some examples of companies that cannot use either of these methods: For DCF, one of my favourite examples is Neptune Orient Lines (NOL), it generates little operating cash flow while spending a large amount in investing activities (this isn't capital expenditure, but does include it), information from SGX website. While for DDM, Berkshire Hathaway, owned by the famed Warren Buffett has only paid a dividend once in its history. These two examples shows the weaknesses of both models and the need for two models to value companies.

Thoughts on the two models......

Personally, I prefer the DCF Model to calculate the value of a company as it shows a clearer picture of the overall health of the company, rather than just by the dividends that it is paying out, which is not indicative of the health of the company as a whole.

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